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The Heated Debate Over Shale Gas

Addressing both sides of the discussion about the quantity and economics of U.S. natural gas.

One of the few bright spots in the American economy that almost everyone seems to agree on is the energy sector. Advancements in drilling technologies have made it possible to extract vast quantities of oil and gas from shale formations.

The resultant boom in natural gas production drove prices to a decade low back in April, providing U.S. consumers and companies with a cheap source of electricity. In fact, according to some commentators, low natural gas prices have even spawned a "renaissance" in U.S. manufacturing, by way of lower energy and feedstock costs.

The massive growth in shale oil and gas production marks a drastic departure from perceived realities just a decade ago, when most commentators asserted that the U.S. would become a major importer of natural gas. Now, it turns out, we may actually become one of the biggest exporters of natural gas by the close of this decade.

But not everybody agrees with this conventional view. In fact, as an energy conference at the University of Texas last month highlighted, there is a debate raging about the future of shale oil and gas production and its implications for the U.S. economy. Let's take a closer look at the two sides of this discussion.

The debate over the true potential of shale oil and gas The shale oil and gas story is no doubt a convincing one. Natural gas extracted from shale deposits already accounts for a tenth of the total U.S. energy supply, up from next to nothing just a decade earlier. U.S. crude oil production is the highest it's been since at least 1998. These are facts that most everybody can agree upon. But the potential of shale oil and gas going forward is where we encounter drastically divergent views.

On the one hand are analysts, geologists, and other experts who claim that shale wells suffer from steep decline rates. According to them, shale wells produce massive quantities of oil and gas in the first couple of years but then quickly turn into "stripper" wells -- those that produce only insignificant quantities of hydrocarbon. If these skeptics are right, then the American shale gas revolution should die out just as fast as it was brought to life.

On the other hand are those who argue that decline rates aren't nearly as bad as the pessimists claim. They believe that the sheer quantity of natural gas available in the U.S. will offset the relatively higher decline rates of shale wells.

The two sides of the story Among the pessimists, Arthur Berman has risen to the forefront as one of the more prominent and widely read shale gas skeptics. Berman, a petroleum geologist and energy consultant based in Houston, has argued that the U.S. will witness a steep decline in gas production because we don't have the capacity or the economic incentive to replace the old, quickly declining wells with new ones at current price levels.

According to Berman, the hype surrounding the shale gas revolution has averted attention from a harsh reality -- the sharp reduction in conventional gas production. But unlike the optimists, he believes the current high rates of shale gas production growth cannot be sustained and will fall sharply in coming years. He told POWER magazine:

It's not a problem for today or tomorrow, but it is coming. Once we work through the current oversupply, if capital is not forthcoming, prices will spike. The gas supply bubble will burst.

The part of Berman's argument that made the most sense to me is how many new shale wells need to be brought on just to maintain a given level of supply. According to his calculations, shale wells decline at rates of between 30% and 40% per year. By contrast, conventional wells have decline rates in the 20% to 25% range. This means a sharply higher number of new wells need to begin production each year just so that supply can stay flat.

Berman's analysis of shale wells in the Barnett Shale, where Chesapeake Energy(NYSE:CHK), Devon Energy(NYSE:DVN), and EOG Resources(NYSE:EOG) are three of the leading producers, provides a rather alarming example. According to his calculations, the annual decline in total gas resources in the Barnett is 1.7 billion cubic feet per day. For net production in the Barnett to rise, it would require energy companies to drill nearly 4,000 wells at a total cost of roughly $12 billion, he argues.

On the side of the optimists, Terry Engelder makes another convincing argument. Engelder, a geologist and professor at Penn State, believes that shale wells offer a much longer period of production than conventional wells. He agrees with the skeptics that shale wells produce copious quantities of gas initially, which is then followed by a sharp drop-off in production. But he maintains, unlike the skeptics, that shale wells can keep producing for a much longer period than conventional wells, even after the initial decline.

Final thoughts and the natural gas supply-demand balance Both sides make convincing arguments. After assessing both views, I am inclined to think that there is a good chance that domestic gas supply has been overestimated -- by how much, I'm not sure. And then there's also the possibility that demand may have been underestimated.

So far, low natural gas prices have spurred tremendous growth in demand. That demand has come from utilities, many of which have switched from coal-fired plants to gas-fired ones, the manufacturing sector -- especially from chemical manufacturing companies -- and the residential sector.

Going forward, overall domestic natural gas demand may improve further, as LNG exports start to come into play and natural gas vehicles become more common. Indeed, natural gas vehicles may prove to be the wild card that sends domestic gas demand soaring.

Westport Innovations(NASDAQ:WPRT), which is paving the way for transportation technology that uses natural gas, certainly hopes so. The Vancouver-based company is a pioneer in the development of low-emission engine and fuel system technologies that allow petroleum-based fuel engines to use natural gas.

It has already partnered with Ford(NYSE:F) and Cummins(NYSE:CMI) to construct natural gas engines for trucks. While it's difficult to predict the speed with which natural gas vehicles will be adopted, the trend is undeniable. Westport isn't alone, either. Numerous other companies are investing in natural gas vehicles and infrastructure.

Clean Energy Fuels(NASDAQ:CLNE), which constructs and operates a growing network of natural gas fueling stations across the country, linked up with truck and engine manufacturer Navistar(NYSE:NAV) last February. The joint venture entailed having Clean Energy provide the truckmaker with a comprehensive fueling solution, including compressed natural gas (CNG) and liquefied natural gas (LNG), designed to meet Navistar customer demands and encourage further interest in this growing market.

Hence, over the next several years, I think there's a meaningful possibility that demand outpaces supply and leads natural gas prices to rise higher and faster than expected. The current massive natural gas inventories will probably take a while to work through, but if shale production drops off sharply, as the skeptics suggest it will, higher prices should broadly benefit North American natural gas producers, as well as coal companies, which compete directly with natural gas as a source of energy.

Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Clean Energy Fuels, Cummins, Ford, and Westport Innovations, owns shares of Clean Energy Fuels, Cummins, Devon Energy, Ford, and Westport Innovations, and has options on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.